What Are Real Estate Investment Trusts (REITs) And Should I Invest In Them?
Victoria Araj7-minute read
July 24, 2021
For many investors, it’s hard to beat the allure of investing in real estate. In fact, among investors there is a robust, ongoing discussion over whether real estate is a better long-term investment than stocks.
REITs (that rhymes with “streets”) offer investors the best of both worlds. When you buy a share of a real estate investment trust (REIT), a REIT fund or a REIT ETF, you are buying a share of the real estate (and its profits!) that are owned by the trust. You don’t have to do any of the work associated with real estate investment, nor do you have to attend closings – these shares are securities that are bought and sold on major stock exchanges.
Let’s take a look at how REITs work and whether they should be part of your investment portfolio.
What Is A REIT?
A REIT is a real estate investment trust that owns, operates or finances properties that produce income in a particular sector of the real estate market. Investors can buy publicly traded shares in a REIT, a REIT fund on major stock exchanges, or a private REIT to diversify their portfolio and generate income.
REITs make their money through the mortgages underlying real estate development or on rental incomes once the property is developed. REITs provide shareholders with steady income and, if held long-term, growth that reflects the appreciation of the property it owns.
How Are REITs Created?
REITs were created by U.S. law as an investment vehicle for those interested in passive real estate investments.
Internal Revenue Service (IRS)
The Internal Revenue Code defines how REITs are formed and the guidelines they must follow regarding asset taxation. These rules dictate how REITs are formed and managed. The Code specifies that REITs must hold 75% of their assets in cash, treasuries or real estate, and must distribute 90% of its taxable income in shareholder dividends each year.
Securities And Exchange Commission (SEC)
There are both public and private REITs available for investment. We’ll discuss the differences below, but for now, understand that publicly traded REIT or REIT fund shares are securities subject to regulation by the SEC. As such, publicly traded securities must comply with strict SEC rules aimed at fostering a competitive and fair marketplace.
What Types Of Properties Do REITs Invest In?
REITs specialize in investing in a variety of income-producing properties. Let’s take a look at a few common ones.
These are REITs that own and operate residential rental properties. These can include single-family rentals to multifamily apartment buildings. The value of these REITs fluctuates along with the demand for rental housing.
Residential REITs tend to be more recession-resistant. No matter the economic situation, people need to live somewhere. When times get hard, people stop going to the movies and buy cheaper goods so they can pay rent.
These REITs concentrate on managing commercial properties. This category includes properties like shopping malls or other retail facilities, office buildings, warehouses or industrial facilities. They often offer higher returns than residential REITs because they’re more susceptible to economic fluctuations.
A good, albeit troubling, example of market fluctuation is the recent economic impact of the COVID-19 pandemic. If you had purchased shares of a commercial equity REIT specializing in Manhattan office space at the end of 2019, you might have been confident that you’d be seeing some big returns right now. You couldn’t possibly have anticipated the impact the pandemic had on emptying those very office buildings whose rental income you were counting on.
Health Care REITs
These types of REITs specialize in properties related to health care. From senior housing communities, to research centers, to medical office buildings, these types of REITs come with their own benefits and risks. They work best in a diversified portfolio where other investments aren’t subject to changes in health care policy or medical demand.
How Do REITs Generate Income?
REITs generate income for investors either through interest payments on the property’s underlying mortgage or rental income once the development is completed.
Mortgage REITs (mREITs) derive their income from interest on mortgages. Each type of property is built with the proceeds of a mortgage, and some REIT investors collect the interest paid on the mortgage as income. They’re popular because they return the relatively high interest payments collected on commercial mortgages.
Commercial real estate mortgages come at a higher interest rate because they’re considered riskier than those underlying residential real estate. Thus, investors in commercial mortgage REITs will earn more interest (while assuming more risk) than those investing in residential real estate mortgage REITs.
Once built, each property type generates rental income, which, after collecting fees for property management, provides income to its investors. Because interest rates are currently at or near historic lows while rents are very high, today’s most popular REITs operate as equity REITs. These trusts generate income from renting real estate to tenants.
After paying expenses for operation, equity REITs pay out dividends to their shareholders on a yearly basis.
Hybrid REITs contain both equity and mortgage holdings. They give investors more diversity, offering better protection from real estate market swings. They can work well with both income- and growth-oriented portfolios.
How Can I Invest In REITs?
Buying publicly traded REITs is easy, but for private REITs, you’ll need to be an experienced investor with substantial assets.
Publicly Traded REITs
These REITs trade on a stock exchange, such as the Nasdaq or the New York Stock Exchange (NYSE). They’re highly liquid – meaning they can be bought or sold at any time so your money isn’t tied up – and are open to all types of investors. You can open a brokerage account with any online trading platform and begin purchasing REITs.
Publicly traded REITs are the way most people invest in real estate.
Publicly Non-Listed REITs
This type of REIT is offered to all but not listed on stock exchanges. There are both legitimate reasons for this – as when a project requires a low profile for competitive reasons – and unscrupulous ones as well. These projects typically offer little transparency and often charge upfront fees, so you need to know who you’re dealing with and have a keen understanding of the project and its risk.
The potential upside is a bigger return that reflects the greater risk you’re incurring. However, there are significant potential downsides as well for novice investors. To comply with SEC regulations, these REITs need only file a report with the agency. In addition to the risk of fraud, buying into a public non-listed REIT means you are forsaking the consumer protections and avenues of redress afforded by SEC regulations.
These investment types are not open to the public. They aren’t registered on the SEC and are only sold to institutional investors or accredited investors. These REITS usually have high minimum investments and are considered illiquid investments, as they can be very hard to sell.
What Are The Benefits Of Investing In REITs?
REITs offer investors several advantages compared to other investments.
Passive Real Estate Ownership
A passive real estate investment is one where you enjoy the benefits of real estate ownership without having to endure the headaches of managing the investment property.
The IRS requires that REITS distribute 90% of its taxable income to shareholders. These payments come to investors in the form of annual dividends.
Generate Steady Income
Whether it’s an equity REIT collecting rent or a mortgage REIT collecting interest, these investments generate a regular, dependable income. That’s why REITs have traditionally been seen as a good investment for retirees, although with the real estate market booming, that view is beginning to change.
Because these investments can be bought and sold on major stock exchanges, REIT investors enjoy liquidity, or the ability to quickly convert an investment into cash. Investors who purchase real estate directly often run into cash-flow problems as physical real estate is illiquid, because it takes time to convert a property into cash.
What Are The Disadvantages Of Investing In REITs?
REITs also have some potential downsides when compared to other investments.
Slower Capital Appreciation
It’s long been believed that REITs don’t grow in value as quickly as other investments can. This is a reflection of that ongoing split in opinion about whether REITs or stocks are better investments in the long term.
Anyone paying even casual attention to the real estate market knows that it’s currently on fire. Because of this rapid appreciation, according to Nareit, the REIT industry’s trade association, many REITs have outperformed the broader stock market.
Taxed As Income
Unlike most real estate returns on investments, the dividends you receive from REITs are not given preferential tax treatment. Dividends are taxed as ordinary income. You should discuss with your financial planner whether the returns on this investment vehicle might move you into a higher tax bracket.
Sensitive To Interest Fluctuations
REITs tend to suffer in an environment of rising interest rates. Investors tend to switch to treasury bonds at those times, because they are backed by the full faith and credit of the U.S. government.
As interest rates on consumer credit rise across the board, your shares may become less valuable relative to shares that are just as low-risk but that offer a higher return because of rising mortgage rates.
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